California sells $750 million in bonds to mystery buyer

(Update: The buyer of California’s Build America Bonds was identified as Fairfax Financial, a global insurance and reinsurance company based in Tononto, Canada. Its U.S. subsidiaries include Crum & Forster and OdysseyRe.

“The investment in California Build America Bonds was a natural investment for us,” Fairfax Chief Financial Officer Greg Taylor says. It was “attractive on both a return and a risk basis.” The company, which has more than $20 billion worth of investments, owns about $5 billion worth of U.S. municipal bonds.)

California sold $750 million worth of 30-year Build America Bonds to a mystery buyer today, the Treasurer’s office reports.

These general obligations bonds, nicknamed BABs, are sold by states to finance infrastructure projects. Unlike most general obligation bonds, which pay tax-exempt interest, the interest on BABs is taxable. As a result, BABs have significantly higher yields than comparable tax-exempt bonds.

Congress created BABs early this year as part of the stimulus act. Under the program, the federal government gives states 35 percent of the interest they pay on BABs. This federal subsidy is usually greater than the actual difference between what a state would pay on a taxable versus a tax free bond, resulting in a tidy profit to the state.

“It’s a wealth transfer from the federal government to the states,” says Matt Fabian, managing director with Municipal Market Advisors.

The mystery buyer, which has only been identified as an institutional investor, approached the state on Oct. 23 about buying a big batch of BABs. This process, known as a reverse inquiry, is fairly common in the taxable bond market but highly unusual in municipal bonds.

In a little over a week, the state put together a $908 million public offering of BABs. The mystery investor took $750 million. Other institutions bought the rest. The state has not offered BABs to retail investors, like it has with other bond issues. Tom Dresslar, a spokesman for the Treasurer’s office, says that’s because BABs are usually 25- or 30-year bonds and retail investors “typically don’t buy those maturities.”

Dresslar says the buyer might be identified when the deal closes on Monday. Market sources speculated that Pimco, the Newport Beach bond giant, or a foreign investor could have been the purchaser. A Pimco spokesman says, “We do not comment on whether or not we have participated in a specific transaction.”

The California BABs sold today yield 7.263 percent, which is about 3 percentage points more than 30-year U.S. Treasuries.

The state will pay just 4.74 percent on the bonds, after the federal subsidy. That’s a nice rate for the state, considering it will sell 25-year tax-exempt bonds tomorrow with an estimated yield of 5.5 percent.

California sold $5.23 billion worth of BABs in April and $1.75 billion worth in early October. Dresslar says the state will save about $1.35 billion over 30 years by issuing those two deals as BABs rather than regular general obligation bonds.

BABs are also a good deal for states because the universe of investors for taxable bonds is much larger than the pool of tax-exempt investors. Foreign buyers have been big BAB buyers. Fabian estimates they might have purchased one-third of the BABs sold in the second quarter.

As of Friday, states had issued about $48 billion worth of BABs. There is no limit on the amount of BABs states can issue before the program expires at the end of 2010.

Fabian estimates that the interest subsidies will cost the federal government $2 billion a year or $55 billion total, net of taxes.

Dresslar says it will be up to the California Department of Finance to decide how to spend the latest BAB proceeds. My suggestion: speeding up those Bay Bridge repairs.